International | Apr 18 2006
Evidence may indicate the Japanese economy is growing in line with the estimates of the central bank, but the Bank of Japan’s (BOJ) ability to see into the future may have serious implications for both the Japanese and global economies.
As Morgan Stanley points out, a key to stability in financial markets is a credible central bank, so the BOJ’s approach to official interest rates in coming months could either make or break the reputations of those setting monetary policy.
The recent move to end the policy of excess liquidity was well regarded by the investment community globally as the evidence continues to suggest Japan is entering a period of sustainable economic growth. That may have been the easy part though, as financial markets are now pricing in increases to official interest rates before the end of the year, meaning the pressure on the BOJ to get its policy right has increased.
Morgan Stanley suggests there is little evidence to suggest rates should be lifted immediately, as inflation is within the BOJ’s target range and while the labour market remains tight, the signs point to rising productivity.
Additionally, the broker suggests there is little evidence of a bubble forming, as though the Japanese stockmarket gained more than 40% last year it has risen less than 10% so far in 2006, while property prices are only improving in certain areas of the country.
It suggests then any move on interest rates in the short-term would be seen as pre-emptive, the implication being confidence in the BOJ’s ability to manage the economy would soar if subsequent figures supported its decision but potentially crumble if the economy were to slide back into recession or deflation reappeared.
Assuming the decision was wrong the likely outcome is a loss of confidence (again) in the Japanese economy, which would see the Nikkei fall and money move elsewhere. The market is currently factoring in an initial rate rise in the Japanese summer, with most experts predicting a 0.25% increase will be announced in either July or August.
If such a move proves correct, it would mean hedge funds have some decisions to make in terms of what to do with the carry trade, where they have borrowed money in the currencies of countries with low interest rates (official rates in Japan have been effectively zero for about five years) and reinvested the proceeds in higher yielding assets. These have included anything from US bonds for those seeking less risk to New Zealand and Icelandic Bonds for those investors that are more aggressive.
If a move by the BOJ to lift official interest rates coincides with the ending of rate increases in the US, the spread in rates between the two countries will narrow. This is not too significant if only a 0.25% increase comes into play in Japan, but further rates increases there could see some hedge funds begin to unwind their carry trade positions.
The likely outcome of this move would be money flowing out of the US, which has negative implications for asset values in that market generally and equity and bond prices specifically.
As a result, while the central bank continues to say policy will be decided by the data available, the potential for pre-emptive moves on the level of official interest rates means it is not only the Japanese who will be watching the actions of the BOJ with renewed interest in coming months.
